Market Insights

Costa Coffee: How it Hedges Coffee Bean Prices

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Out of all the commodities traded the world over, one of the most popular ones is easily coffee. So much so, in fact, that it's the second most-traded commodity on a global scale. With that, it's also prone to a whole lot of price volatility.

Costa Coffee

A major  player in the coffee trade industry is Costa Coffee. They hedge both foreign exchange and pricing risks in order for volatility to be lessened. However, what many people may not realize is that coffee beans are not the biggest cost of Costa Coffee. Instead, the British company actually shells out quite a lot for milk.

That said, hedging coffee's price has become equally key for Costa Coffee's treasury manager, Jill Harrison. "That's very high up on my priorities," she said. Harrison was a speaker at a Treasury Leaders Summit in recent years.

When it comes to coffee, the elements to risk are dual: Commodity price, since coffee contracts are usually in dollars, and exchange rate movement. While Costa Coffee is a pound sterling business with operations primarily in the United Kingdom, their coffee purchases are in dollars. That's how they end up exposed to dollar and sterling fluctuations.

"It's really important ... that the strategy [to hedge risks] comes from the top," Harrison said.

It's important for Costa Coffee's board to communicate any key risks they see, alongside the vital things to protect. All of that should then be filtered and placed in a finance policy that, in turn, informs the treasury policy and ultimately feeds the FX (foreign exchange) strategy.

Hedging Risks

Costa Coffee fixes their sterling-dollar rate, and their coffee is generally bought ahead of time.

The treasury needs to understand the business' overarching considerations when day-to-day risks are being managed. While all companies vary considerably, most treasurers have a tendency to really have an increased focus on hedging risks. This is because there have been a number of geopolitical shifts over the last two years. Another factor is connected currency volatility.

Given the popularity of coffee in terms of trades, future pricing predictions when it comes to the market are usually reliable. Coffee pricing is impacted by basic supply and demand. Weather is a concern; there are two coffee crops per year. One of them is in May, while the other is December. This can have an impact on coffee bean qualities and volume per harvest, too.

There's a "green coffee committee" in Costa Coffee that involves representatives from the senior finance department, procurement, supply chain and treasury. The committee meets on a regular basis so they can assess what's going on in the coffee market, weather and harvests and all. This is where they base recommendations on when it comes to the levels of coffee businesses should buy.

Harrison said that Costa generally sets a fixed cost for the coffee they buy, usually two harvests ahead. This is ideal for the treasury team to separate the pricing risks from others.

Core Coffee Markets

Buying and selling green coffee can be done in one of two ways: the futures market and the cash market.

Cash Market

Green coffee's cash market is basically explained as the physical exchange of coffee being delivered, sold and bought. Participants include exporters, importers, producers, traders, and roasters. This is the most basic level of trading: there's a certain rate at which coffee is sold. The rating is based off of the value in that moment.

While the cash market sounds prime for immediate purposes, when it comes to the coffee industry, that's not always the case. Yes, it can refer to a spot purchase (which is generally the term used for immediate purchases) but it can also be used for a forward contract. The latter involves a buyer committing to long-term coffee purchases over the years.

A roaster can, for example, commit to buying coffee of a certain cupping score at a fixed amount for the next three years. They will agree to paying a particular percentage over the coffee price internationally at the time of the harvest. This becomes a forward contract on the cash market.

It should be noted that most physical coffee exchanges happen by way of forward contracts.

Futures Market

Futures market trading is a different story. In a futures contract, two parties set an agreed price on a commodity to be delivered at some point in the future, even if the market-determined price of that commodity has fallen below their agreed-upon price.

Simply put, no matter what coffee's market rate is during harvest or delivery, the predetermined rate will apply.

For example, let’s say a futures contract was signed for five million pounds of coffee. Let’s assume that the market rate for coffee at the time of harvest is $1.50; however, the futures contract they signed reads $2.00. In this case, they will have to pay the market rate of $1.50; however, should the market rate increase to $3.00 by harvest time, they will receive the lower $2.00 price.

Future contracts are generally between licensed participants on platforms that are government-regulated like the ICE in New York, which is also known as the C market. The trading on that end is more towards Arabica. For Robusta, London's LIFFE is involved. Both ICE and LIFFE set coffee's price, called "the C price."

There's an additional stipulation that green coffee has to be traded in specifically weighed lots: 37,500 lbs each.

That said, when coffee is treated as a commodity, there are bound to be cracks in the system. Coffee is treated as a uniform product as a whole. Factors like cost of production, quality and origin are essentially irrelevant at that stage. Various infrastructures exist within countries that produce coffee; there's also a wide range of coffee beans produced.

Hedging FX Risks

During her talk, Harrison shared that when she joined Costa Coffee in 2017, she reviewed the foreign exchange (FX/forex) strategy. There were three key hedging strategies that underwent assessment:

Static Hedging

This is when the treasury sets their budget rate for the whole year at the financial year's very beginning. However, since they weren't looking for that budget rate to be protected, it did not work out in the long run.

Rolling Hedging

After static hedging was clearly not working out for them, Costa Coffee explore rolling hedging. Unfortunately, it didn't work out either. "It was too flat," Harrison explained simply. The coffee company's purposes did not get enough of a dynamic hedging strategy through this method.

It was at that stage that the treasury team took on another attempt at making things work.

Rolling Hedging With A Shorter Schedule & Cash Outflow Considerations

This move by Costa Coffee's treasury team essentially closes out existing positions when they come close to maturity. At the same time, new positions are concurrently opened, with maturity dates being much further down the line.

When cash flows get far less sure when it comes to dates over time, Costa will then hedge a much small proportion of the risk. They will then reassess their position later on. It means that Costa Coffee has hedges maturing at any given time, all of which have different contracting dates.

"[We've reviewed how this worked] in the past versus what would have happened if we'd taken a different approach to hedging," Harrision stated. The review then confirmed how the approach was ideal compared to the other methods they'd tried out.

Essentially, they then have a blended rate that evolves over the passing of time. It affords them helpful visibility on the incoming rate, minimizing volatility.

Hedging & the C Market

Green coffee's international market rate is the C price. This is heavily affected by supply and demand. Any falls in demand or increase in supply brings the price down. On the other hand, prices go up when supply decreases or demand increases.

When a futures contract is signed, demand is demonstrated and future supply is affected also. Futures contracts sales then affects the C price directly. It's vital to take into account not just who is doing the coffee trading on the futures market, but also their reasons behind it.

The C market's groups are divided as follows:

  • Managed money - 35% of the overall market
  • Swap dealers - 14% of the overall market
  • Traders in the coffee industry (roasters, merchants, producers, etc.) - 36% of the overall market

There are also other parties, who collectively make up the remaining 15%.

Traders are the ones who use coffee; they hedge for their risk to be reduced. Managed money, on the other hand, uses the futures market for purposes of speculation. They buy and sell coffee in order to possibly profit for clients, including banks and investment funds.

The futures market is used by swap dealers to make commodity swaps. Those financial deals are complicated in order to offset risk. Best of all, it could lead to profits down the line. There is no want to possess or use coffee on this end.

Coffee As a Commodity

Since coffee is treated like a commodity and traded on a market, its price may be affected by other commodities such as wheat, iron, or gold. There is a wide range of commodity markets on a global scale that investors use to trade in transactions that are purely financial. This is instead of physical trades, wherein actual goods are brought on.

Traders buy and sell whatever they find attractive on any given day. Given that uncertainty, there's a tendency for the C price to fluctuate a whole lot.

Simply put, market activity is largely held by players who are not involved in the coffee industry. However, the global price of coffee is affected by all of it as a whole.

Simplicity Is the Key

During her talk, Harrison pointed out that Costa Coffee is always looking to keep things simple on a consistent basis. It's vital for stakeholders to be able to process and understand what they do and what they hope to achieve all at once.

"If we do anything much more complicated in terms of our contracts for currency and coffee," Harrision explained, "then we start to have hedge accounting problems which we don't want to come across."

Their approach is essentially far simpler than others, but it works very well for Costa Coffee.

Today, financial services providers such as banks have started to approach Costa Coffee with hedging products that are more sophisticated, options products and more complex financial instruments than what they previously took on.

Producers & the Futures Market

The disconnected relationship between the C price and the cost of production has an adverse affect on smallholder farmers. The prices they receive from buyers rarely incorporate the cost of production. If the C price drops, small holders are left with little or no profit margin. Meanwhile, the rest of the supply chain is enjoying healthy margins.

Costa Coffee & Future Hedging

A few years ago, the British coffee company is already looking forward to differentiating hedging methods down the line. As it is, they have already established legacy hedging for some time now. It's something that happened to the company organically.

Costa Coffee is priming itself to make a portfolio that's not just driven by maturity, but also by products. Options have a stigma around them, so the treasury department of Costa is reviewing things very carefully.

If they use options, the company will need to take a position on future currency valuations. It's an opportunity to creatively think about how Costa's risk management can be handled.

Conclusion

Costa Coffee is one of the leading British coffee companies out there. It's a major player in the global coffee industry as well. They place a lot of value in terms of hedging the price of coffee. So much so that they have found a simple yet powerful way that works for them: rolling hedging with a shorter schedule and cash outflow consideration. That said, they are still exploring various hedging methods for their use in the future.

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