Drop Dead Garrulous

Garrulous: Given to excessive and often trivial or rambling talk; tiresomely talkative, especially on trivial matters.

Specialty Coffee has come a long way from the times when most aspired to be like Starbucks to now when most aspire to be most unlike Starbucks, but I believe companies may be better served taking a peek at what Big Green is doing right. Like it or not, Starbucks is still growing and is having an even bigger impact on coffee perceptions and customer expectations. Starbucks focuses very well on their customers wants and is constantly probing for the right formulae. Howard Schulz (Starbucks CEO) speaks with a very clear voice on satisfying expectations, delivering value and delighting their patrons. Starbucks achieves this by focusing solely on the customer.

Concurrent to this Specialty Coffee has been engaged in an exercise of self-indulgent narcissism that is completely removed from the customer experience and has more to do with gazing in the mirror than looking at the customer. Whether it is the proliferation of new and trivial competitions where contestants are encouraged to elucidate their solitary experiences and the judges stand in as proxies for real customers, or an effort to elevate the barista so far above mere counter service that they fail to serve effectively, the result is the same, an industry so engaged with itself that they've disengaged from the customers.

Very recently a twitter thread appeared in my timeline (re-tweeted by someone I admire and follow) concerning the inconsequential but fashionable topic of cold brew, leveraging standards and protocols that a lab would have a difficult time reproducing. The impression that the garrulous participants (two former Board Members of the Specialty Coffee Association of America) were clearly debating not so the customers might have a better experience, but so their audience might be impressed with their staggering mastery of all things trivial was not lost on the re-tweeter. These exchanges happen every day among the leaders of the Specialty Coffee Industry and are hard to miss given the disproportionate number of times these threads appear in SCAA publications and their social media feeds thereby securing the Associations implicit nod of approval.

Presently we portray an industry that has moved from taking twitter shots of latte art to examining nonsense in minute detail and fetishizing exotic coffees and preparation techniques in the hope of gaining affirmation from our peers instead of our customers. We have completely failed to understand that it’s the customers experience that matters, not the barista’s and that a great conversation over average coffee at Starbucks is better than a great coffee and a performance at (insert café name here). We don’t get it, but Starbucks does.

Here’s hoping that current and future SCAA Leadership and Executive Council positions are populated with people who act like customers, not competitors.

*Drop Dead Garrulous is (what I think) a clever play on words and not a desire that anyone die or be otherwise harmed as a result of my post.

Pay Your Taxes...All of Them!

This is a friendly reminder in this season of the taxman, to pay up!
Importers, Roasters, Cafes, Cafe Owners and Barista all have special and individualized obligations to accurately and truthfully assess and remit tax returns to their respective governments. Governments have special powers to make sure you eventually pay your taxes or face stiff fines, staggering interest rates and even jail time.

While I don't know much about the tax code here in Canada (my accountant does) let alone the Euro Zone, Pacific Rim or the US, I do know that failure to submit a return and tax fraud (intentionally lying on a return) is reserved for especially harsh treatment by the authorities, so here's my advice.

1. Get your paperwork in front of a qualified bookkeeper, accountant or tax professional in good order and on time.

2. File your completed and accurate tax forms on time even if you don't have the money to pay what is due.

3. Immediately contact your government tax office and make arrangements to pay off any tax that is due in a time period you can afford.

4. Business owners must absolutely pay payroll, sales, health taxes and report them accurately. These monies are generally collected by the business owners from customers on behalf of the government and is therefore held "in trust". Failure to pay these taxes can result in the government immediately seizing your bank accounts and shutting down your business overnight.

5. Ignoring the problem will definitely end up in personal and business failure...guaranteed. There is an infamous case of an espresso bar owner who at year end will owe over $800,000 and with it compounding at an annual rate of 20%, will owe over a million dollars next year.
Life changing, life sentence. Pay Your Taxes...All of Them

The Shared Hedge

The Exchange Traded Commodity Price for Arabica (The "C")has been a consistent topic within this blog. It is of such vital importance to both farmers and consumers that I've dedicated a great deal of thought and effort to articulate the factors that affect the price settlement every day. Last year in the middle of a flurry of attention following the price eclipsing $3.00, I posted some thoughts on delinking the Specialty Price from the commodity price although with somewhat sketchy details about basing it on a composite retail price.

In the past few weeks I've begun to flesh out some ideas with the goal of providing some security (hedge) and stability (certainty) within the Specialty Coffee market. This proposal is not universally suited for all and admittedly excludes parties driven solely by profit. First, I'm restricting this concept to those companies who purchase direct from farm, where interaction and negotiation with decision makers at source is possible. Second,this mechanism is intended for growers and purchasers who are both dedicated to price stability with sufficient risk/reward to satisfy normal profit motives. Last, the integrity of the proposed contracts must be unassailable as each participant is the counterparty insuring the hedge.

The proposal is the creation of a proprietary Tailored Options Contract (think of it as an insurance policy) which would be negotiated by each party under the auspices of a Third Party Registrar. This contract would be very different from normal exchange traded options contracts where the counterparties never know who is on the other side of the trade.

The basic structure can be best explained by the following: The Roaster sells a Put at the agreed strike price with an approximate 10% premium which is purchased by the Grower. The Grower Sells a Call at an agreed strike price with an approximate 10% premium which is purchased by the Roaster. Both share an expiration date at harvest the following crop year, for example Jan 1,2013
Example: Let's assume the agreed price for this years crop is $3.50 per pound farm gate. Our Roaster sells a January 2013 Put Option to the grower at $3.15 Strike Price and and receives $0.35 in proceeds. This gives the Grower the Option, but not the obligation to sell his/her coffee next year for $3.15. The Roaster who sold the Put in turn has the obligation to purchase if the Grower exercises his right. So why would the grower exercise his option to sell at $3.15? Let's say next year, the commodity price falls significantly such that similar specialty grade coffees are now selling for $2.50 per pound, by exercising his right to sell at $3.50 the grower has greatly limited his downside risk for next year.

Concurrently, the Grower sells a January 2013 Call Option to the Roaster with a $3.85 strike price and receives $0.35 in proceeds which offsets his/her cost of purchasing the Put. This gives the Roaster the Option, but not the Obligation to purchase coffee next year for $3.85. The Grower also gains the obligation to Sell at $3.85 should the Roaster exercise his right. The Roaster would choose to exercise his right to purchase at $3.85 if the price of similar grade coffees is higher than $3.85, limiting his exposure to even higher prices for a year. The effective result is that Roaster has the Option (but not the obligation) to purchase coffee next year at a 10% increase over this years price. The grower in this scenario will lose the profit potential should the price increase beyond $3.85. Should the price fall instead of rise, the grower has the Option (but not the obligation) to sell coffee to the Roaster at a price 10% below this years price.

The net result is that the exchanged options contracts keep the price within a 20% (10% up $3.85, 10% down $3.15) price range for the next year (2013). If the Commodity price moves vastly higher during 2012, the Roaster can lock in his 2013 Option and buy for $3.85. If the Commodity price moves vastly lower during 2012, the farmer and lock in their January 2013 Option and sell for $3.15. The middle ground is where both parties agreed at the beginning of the year that they wanted the price to be. By creating a specialized Options Contract, the two parties can be certain that under all circumstances that will be the case. If by chance the price remains stable for the year, the options expire and a new contract can be enacted using the same method to achieve stability for the new crop year. The beauty of this model is the spread between the prices which defines the target price for next year can be literally as wide or narrow as the parties desire, and the premiums set accordingly. The premiums can even be structured so that one party pays a lower premium than the other owing to increased risk or asymmetric strike prices on either side of the current price.
In any case the grower foregoes the upside potential beyond the strike price increase, the Roaster foregoes the savings beyond the strike price decrease. Price Stability=Shared Risk= Win/Win

Enacting the proposed structure would greatly benefit from participation of several large independent roasters/importers who are dedicated to farm support and transparency, but also with marketing programs in place to adequately articulate to customers how they are guaranteeing farm income. Alternatively I can imaging an existing Third Party Certifier adopting this type of contract model and branding it as a simple and cheap mechanism to benefit farmers and roasters alike. Remember, the Importer/Roaster benefits from price stability as much as the grower. Last, I imagine that a new legal enterprise could be established to negotiate and monitor contracts with a small net debit premium on each side from the sale of the Put/Call Options and branding the contract something descriptive of it's benefits...The Shared Hedge!

If some Roasters/Importers are currently using Private Options contracts I'd be happy to hear about them, and if anyone is interested in discussing the idea further please let me know.

The BRIC's Will Fall

I wanted to give one last update in 2011 on my running commentary on the Commodity Price for arabica coffee. I have been predicting a drop in price all year and expected the price to approach $2.00 by the end of the year. As I type, the price is $2.2090 and pushing up against the resistance set up at $2.20. Time will tell when it breaks through and accelerates down, but the main reason for my post is to shed some light on the conditions within the BRIC nations (Brazil, Russia, India, China) who were credited early in the year by many "experts" as being the reason demand for arabica was exceeding supply. While I completely disagree with this characterization of their current influence (rather than their potential) I thought I should share some actual data which reduces even their potential impact on the price.

Year to Date, the BRIC nations economic vibrancy as expressed through their Equity Indexes have shrank by the following percentages:
Brazil: -18%
Russia: -23%
India: -23%
China: -18%

Given that discretionary consumption is fed by increases in wealth, and that the relative prosperity of those wealthy enough to invest surplus cash in equities has diminished in BRIC nations, the likelihood that coffee will be able to significantly increase market penetration under these conditions is doubtful. While I have read many experts and publications are predicting coffee will again test the $3.00 level, I'd be very happy to invest against that prediction based on current crop predictions and current consumption levels.

Peak Coffee and other BS

Recently there have been a couple of articles (and here)referencing Peter Bakers claim that we are on the cusp of exceeding our planets capacity for coffee production, or Peak Coffee. The term Peak Coffee itself is a nod to M. King Hubberts 1956 paper which suggested that man had discovered all of the oil reserves which were viable, and that mankind was inevitably destined to run out of fossil fuels before long. Of course, the notion of running out of something depends on the levels of consumption which are never fixed, and don't always rise. But coffee is a very different commodity than fossil fuels because it is a crop, and is replenished every year with some regularity.

Lending credence to the idea of Peak Coffee is distasteful and even this blog post gives it more attention than it deserves. For Peak Coffee to be even remotely possible in context the following must be true:

1. Coffee is grown and harvested at levels of efficiency so high as to be impossible to improve. Of course we know that coffee growing is notoriously inefficient, and massive gains in productivity are possible with even small changes in farming techniques.

2. All available land suitable for coffee growing is presently engaged in coffee production. As advances are made in understanding how to grow coffee in a truly sustainable way thanks to organizations such as Rainforest Alliance, more land for sensible, sustainable and productive coffee farms becomes viable

3. Coffee consumption is inelastic to price movements, and higher prices will not effect the volume required. Coffee prices are relatively inelastic, but consumers look for alternatives at prices rise beyond historical level, most often choosing lower cost options. Coffee has always been considered a loss leader in many retail chains feeding support to the elasticity argument

4. There are no improvements to be made through genetic modification of coffee. (Distasteful but a factor non the less) While this option is likely a nuclear option, if sustained prices and increasing demand were not compensated for by other advances, this would be explored

5. The demand curve volume for coffee will be fed by developing nations who have yet to discover coffee as a beverage, but will eventually overwhelm the marketplace. This is predicated on the assumption that consumers in developing nations consumption habits are particularly inelastic to high prices. Coffee is not tobacco, and overcoming cultural preferences is more difficult than we are being led to believe.

6. Consumption growth in the Specialty Coffee segment has no ceiling, and will surpass commodity coffee in commercial importance. Of course Specialty Coffee can be proud of being the fastest growing segment, as did Fair Trade at one point in recent history. But Fair Trade has never achieved wide acceptance even in markets highly sympathetic to Fair Trade such as The Netherlands and there is no reason to believe that Specialty Coffee will enjoy better results. The idea that Specialty Coffee is somehow impervious to price spikes over the long run is foolish and dismissive of the power and influence of the large commodity operators. Even taking wildly inflated figures of 20% of all coffee sold being Specialty Grade, commodity speculators could quite easily commoditize the Specialty Grade trade by purchasing in quantity should stocks somehow approach Peak. For example: If ALL Specialty Grade coffee in the world were to be commoditized, assuming it represents 20% of production, it would only move the commodity price by: ($2.35x.8)+(4.7x.2)=$2.84 or an increase of $0.47 per pound using todays close.(I am assuming a Specialty Grade Price 2x the "C" which is generous on average)

There is much to be said for the possible negative impact of climate change on harvest yields, but it is all speculation and statistically inconsequential on a macro level to date. Equally, there is much to be said about the impact of the possibility of capital markets freezing in Europe reducing liquidity in the commodity trades and increasing the spreads. I think it fair to say that financial markets and currency factors have moved the coffee market far more often than harvest or weather events in the past 2 years. For now, lets put the words Peak Coffee out of our lexicon, and stick with variables which are within the realm of the reasonable.

Trading Coffee Options Part II

Identifying a "strike" price for your option is a fairly simple process of asking your broker for all of the price variations relative to expiry dates. The strike price can be thought of as a derivative of the volatility and probability relating to the "C".
The costs attached to purchasing options are affected by the amount of liquidity in the market (for coffee the liquidity is low and therefore expensive), the time period related to the contract, and the price volatility (volatility increases the price of the option).

Liquidity or lack of liquidity means the amount of active open interest in a series of option contracts. In practical terms, if you are offering something for sale and there aren't many buyers, the "spread" between the asking price and the bid price increases. This is important in situations where you may want to sell a position quickly and be forced to take a lower price than you paid because of a lack of buyers. This type of loss is referred to as "slippage", or the loss taken on the gap between bid and ask on a quick transaction. Conversely, as the price moves either up or down such that it approaches in the money, the spread between bid and ask narrows as interest spikes. Purchasing options on the "C" may be less attractive due to the fact that there is relatively low open interest in coffee options contracts and the price premium for many is unattractive.

Determining the value or cost of time attached to an option is as simple as identifying options with the same strike price, but different expiration dates and recording the value of the extra time. The more time left on the option, the more time for move to occur to put it in the money, the more expensive the option price is.

Volatility or conversely price stability affect the prices of options as well. Price movements which routinely alter the price of the contract in and out of the money, sometimes several times during the period of the contract, will be much more expensive than options on commodities or shares with stable pricing. Lately coffee has experienced some pretty wild fluctuations in relatively short periods of time and therefore the time premium can be expensive in these situations. Currently, the price premium on a coffee contract costs a premium of $0.10 over/under the "c" with a November expiry. For a $37,500 lb contract, the option will cost approximatley $3,750 before you get in the money. This contract works if we are confident that the price for coffee will either increase or decrease more than 10 cents per pound over the next 8 weeks or so.

Remember, as the contract approaches the expiration date, the value of the contract decreases if it is not in the money with each day. The key when trading options on goods with low open interest, high volatility is to stay on top of the pricing and get out of your position the moment you feel it is in the money with transaction costs plus your target premium. Also, with options, someone either wins or loses on every contract. With each option, there is always a counterparty who is betting the exact opposite of what you believe is going to happen will happen. Don't underestimate the intelligence of your counterparty!
I'll take a week and knock off another post on options trading, next time dealing with the process to place an actual order for purchase or sale.

The Event

I'm feeling more than a little frustrated lately at the direction the Specialty Coffee Association of America is taking our industry. This post was inspired by a visit last week to our roastery by a Montreal based packaging equipment manufacturer who sang a familiar refrain, "we don't do SCAA anymore because it's not worth it and we're not welcome". This statement reminded me that last year in Houston I had the opportunity to chat with several attendees of the Specialty Coffee Association annual trade show dubbed "The Event". These folks I would characterize as long time members of the SCAA and exhibitors who purchase booth space on the trade show floor to display their products. Their opinions about the quality of the show for exhibitors was uniformly negative owing in their opinion to the SCAA's focus on "vanity hall" where baristas display various coffee preparation techniques in competition. Others suggested that entire categories of exhibitors were considering pulling out of the show due to the lack of support or respect for their segment of the industry. Others still were disappointed in the actual paid attendance once complimentary, exhibitor, attendees below decision maker level, etc numbers were removed. Finally in Houston, the competition area was physically removed from the trade show floor and served to pull attendees away from the paying exhibitors, making matters worse. I believe the fact that the SCAA has received "an offer it can't refuse" relating to the facility in Seattle, makes the revenue stream from exhibitors less a concern going forward and will lead to further alienation of trade floor businesses.

I have been attending SCAA shows for approximately 14 years, and have observed changes that, in my opinion, make the show less of a compelling event for some. Certainly the training available now through SCAA is exemplary and full credit goes to the Professional Development staff. The addition of a comprehensive Instructor Development Program, standardized lesson plan formats and guidelines and engaged volunteers makes this part of the organization stellar and reason alone to attend any SCAA trade show. However, for the business directors and decision makers with established business plans and formats, there are better options and events to direct your resources.

Years ago, every sector of the coffee business was welcome, exhibiting and in attendance. Packaging machinery and products in abundance, many more green coffee brokers, authors, photographers, Chain Stores and Micro Chains, Tin Suppliers, Mints, Candies, espresso and coffee equipment manufacturers to name a few. It is not lost on the allied members and manufacturers who sell to the industry that the voices that are amplified by the SCAA within it's own publications, in executive positions determining policy, and directing the distribution of SCAA resources are invested in promoting the competition barista and the micro lot roaster/importer as the "Face of the Industry". The failure to recognize that most Specialty Coffee customers do not purchase their coffee from competition inspired baristas, and a complete lack of recognition for operator (collective) excellence within the SCAA leaves me wondering how long the organization can exist with such a narrow focus on the individual.

The SCAA itself will deny any bias, and claim that all segments of the industry are welcome. While this may be their intention, in practice what happens is the equivalent of inviting everyone to your house party, but speaking a language that most of your guests don't understand, playing party games they don't know how to play, and making them pay for the beer and nachos. The people at your party who speak the language, and know the games have fun, but the rest of the party goers eventually leave if they feel snubbed, or are not able or interested to learn to play the games.