Coffee Trading & Hedging Basics

David JoelsoniRely LLC

Purpose: Improve our Customer Understanding

1. Provide General Background on Coffee Supply Chain

2. Articulate keys to trader success to put system capability into business contexta) Distinguish between traditional commercial traders and specialty

3. Explain trading & hedging process in detail to improvea) Futures Market Definition

b) P&L and Cash Implications

c) Basic Hedging & differential trading

d) Hedge “rolling”

Confidential

Contents Coffee Trading Basics

Coffee Supply Chain Overview Supply Chain Transactions

CommercialSpecialty

Summarize: Keys to success in trading Futures Market

General ConceptSimple Transaction – P&L and Cash ImplicationsHedging Examples for TradersPrice Fixing Techniques with suppliers/customers“So you want to be a Trader” Quiz

Market Structure and Hedge RolloverNormal and Inverted MarketsUsing the ‘Carry’ – example & results

Appendix: Aligning Contract Months to Futures Months

Coffee Trading Basics

Supply Chain Overview

Commercial Transactions

Specialty Transactions

Coffee Supply Chain Overview

Producers grow the coffee cherryMills process the cherry to final (pre-roasted) form called “green coffee”

In origin, coffee can be traded in-between state of dry cherry or pergamino

Mills can be owned by farmer cooperatives, exporters, or independent operators

Exporters mill, sort, blend, transport, register, and otherwise prepare coffee for export

Importers typically pay exporters when coffee is on ship and perform logistics (importing, delivery)

Roasters buy from importers on various terms, roast and blend the coffees and sell

Some roasters buy direct from origin “FOB”

Some large roasters have their own trading arms

Typical Large Commercial Transaction

Jan 1: Large roaster buys 3,000 bags/month Brazil Arabica from Importer/supplier, July – December Delivery, of well known standard quality

March 1: Importer buys June ship Coffee FOB Brazil from exporter to meet first delivery, expecting 2 cents/lb profit if nothing goes wrong

By June, exporter (supplier) puts 3,000 bags into 10 containers and ships. Bill of Lading sent to importer who pays exporter (coffee still afloat), or perhaps his bank paysImporter makes customs/FDA entry, pays ocean freight, and moves coffee off pier to a warehouse. Returns container.July: Importer sends 10 samples (1 per can) to roaster who approves qualityImporter issues Delivery Order (DO) transferring ownership to customer (also physically delivers goods at the same time) and invoices roaster

Roaster confirms weights & quality, can file claim Profit on transaction: $8,000

Challenges for Commercial Traders

Knowing total risk position – can be multi-location operation including origin exporting

Understanding the price-value relationship for all customers Managing costs on razor-thin margins

Fierce competition on price

Managing large hedge position in volatile markets (cash) Efficient use of credit: turning over lines of credit & extracting

maximum profit from use of lines Placating suppliers without taking huge risk

Pressure to pre-finance

Price fixation terms

Large customers drive unique terms

Typical Specialty Coffee Transaction Importer travels to remote area of Malawi & finds 72 bags bird friendly, Utz

Kapeh certified Fair Trade Organic coffee w/winey, slightly nutty flavor and the aroma of dried marigolds

Pays $2.00/lb and contributes another 20 cents/lb to build a school in the villageFair Trade organization collects 10 cents/lb for their troubleExporter is engaged for logistics and also sends pre-shipment sample back to importer. Cost to deliver to US, 10 cents/lb

Importer places in warehouse in US, shares samples w/his customers, and sells for $3.50/lb, 3 bags at a time

Issues delivery order to customer combining these 3 bags with 8 other types of coffee to make one half-container delivery Cut invoice Repeat process 25 times/day.Often sales will cover multiple months (25 bags July-Dec) with actual deliveries as called for by the customer

Profit on 72 bags Malawi: $10,000

Challenges for Specialty Coffee Importers

Low physical volume, high transactional loadEach sales contract is likely have multiple qualities, prices, amounts; delivered and invoiced in multiple shipments

Sample management – pre-shipment, on arrival, offerings to potential customers

Tracking inventory: what’s on hand, how much committedAre customers taking the coffee as committed?What if another customer wants the coffee today?

Efficient use of creditDo customers pay on time? Strain on importer’s financing capability

Supplier delivery performanceOften many customers impacted if one shipment is lateIf quality is off there may be no other coffee to replace

Risk position – adding up so many transactions into a coherent overall view

Suppliers may want to buy price to be fixed but in very small (sub-lot) quantities

In General: Keys to Trader Success Quality Management: understand customers & suppliers

Sample tracking Cost Management

Incorporate estimates into selling priceTrack actual costs versus estimatesCosts vary by lane and also by customer

Logistics ExecutionException reporting

Risk ManagementMarket exposure (reports and mark to market) – real timePhysical coffee exposure (reports)Business Practices to minimize counterparty risk

Fixation policy for suppliers and customersMark to market by counterpartyHedge rolling against inventory

Futures Markets

Commodity Futures Market: ICE Coffee A futures market is an exchange where standardized futures contracts are traded

for settlement on various (future) dates Standardized contract terms include (ICE Coffee Market in this example):

Size of each “lot” traded (37,500 lbs of coffee)Quality specs (prime washed Arabica coffee….typically from Central America)Terms (Delivered in store to an exchange certified warehouse)

The price traded on futures market reflects the contract termsOn each futures trade, participants only have to indicate who is buyer / seller, quantity, delivery month, and price. All other “terms” are defined by the standard exchange contract.Commercial contracts for coffee may have a different price than the futures price to reflect differences in terms or risk vs. the exchange standardized contract

The market reflects the actual value of the commodity because each seller (“short”) has the option to deliver physical coffee in compliance with the contract.

The end of each futures month has a “delivery period” reserved for this functionEvery “short” must either buy back the position or delivery coffee to exchangeFor every short position, there is a long position…so when a trader with a short position delivers coffee to the exchange, a trader with a long position is notified by the exchange and must buy that coffee

Transaction Example Buy 1 lot of Coffee May Futures at 130.00 US Cts per Lb Sell 1 lot of Coffee May Futures at 131.00 US Cts per Lb Profit = 37,500 Lbs x 1 Cent/Lb = $375 (less commission)

Cash Implications When I buy (or sell) 1 lot, my broker will require initial margin. For example, $2,000 per lot My broker is protected in case the market moves against me* by $2000/$375 = 5.33 cents If the market moves against me, I will be required to post additional margin (“Variation Margin”). Typically,

variation margin in coffee will equal $375/lot/penny move. If the market moves for me, then broker pays me cash

*If I am long, market up is good and market down is bad. If I am short, market up is bad and market down is good

Illustrative

Hedging Can Cost Money

Coffee trader has 100,000 69 KG bags in Inventory100,000 x 69 x 2.2046 = 15.2 Million lbs

These are hedged with a short futures position15.2 million lbs / 37,500 lbs per lot = 406 lots

If there is a frost in Brazil and the market goes from $1.30/lb to $2.50/lb, how much variation margin will be required to finance the hedge?

Market up 120 cents/lb

Each cent/lb is $375/lot

Margin call = 406 lots x 120 cents x $375/cent = $18.3 Million

Note that this money all comes back when the coffee is sold at high prices based on $2.50 futures. But in the meantime, trader must finance the margin calls.

Hedging Example: Buy fixed price and Sell Price to Be Fixed

Importer Buys 550 69-KG bags (83,665 Lbs) Guatemala Strictly Hard Bean Washed Arabica coffee April shipment for $1.50/Lb FOB when ICE May Futures are at $1.30

Sells 2 lots May at 1.30. Therefore, he “owns” the coffee at +20 Cent premium to futures.His cost to move coffee to Europe is 7 Cents/Lb, where he hopes to sell for +35 cents to make an 8 Cent profit.This coffee is of much higher quality than prime washed coffee, so it should sell for a substantial premium to futures prices

Importer then sells coffee to a customer for May Delivery at +35 Cents differential versus May futures.

When May futures drop to 1.00/Lb, customer calls and fixes price at $1.35/Lb (100 + 35). Importer buys back 2 futures lots at 1.00.

Results of this transaction?

Hedge Example Results(Market dropped to 1.00)

Physical Side Bags Lbs Rate $ AmtCoffee Revenue 550 83665 1.35$ /Lb 113$ k

Coffee Cost 550 83665 1.50$ /Lb 125$ kOther Cost 550 83665 0.07$ /Lb 6$ k Total Cost 1.57$ /Lb 131$ k

Profit/(Loss) Coffee (18)$ k

Futures Lots Lbs RateBuy (Long) 2 75000 1.00 /Lb (75)$ kSell (Short) -2 -75000 1.30 /Lb 98$ k

Profit/(Loss) Futures 23$ k

Combined Profit In Dollars 4.1$ k In Cents/Lb 4.9 Cts/Lb

Discussion Why did trader have to hedge his purchase? What would

have happened had he not hedged?

In previous example:Bought at + 20 Cts/Lb, Costs were 7 Cts/Lb so total cost = 27 Cts/Lb

Sold for + 35 Cts/Lb

But profit was only 5 Cts/Lb, not 8 Cts/Lb. Why?

Instead of going down, what if market went up? Where is profit and where is loss (physical coffee and futures)?

(See next slide for illustration of same transactions except market went higher to $1.50 instead of lower to $1.00)

Hedge Example Results(Market up to 1.50)

In this case, the gain is on the physical side and the loss in the futures hedge. Because the transaction is underhedged, the total profit is higher, 10.1 Cents per Lb

Physical Side Bags Lbs Rate $ AmtCoffee Revenue 550 83665 1.85$ /Lb 155$ k

Coffee Cost 550 83665 1.50$ /Lb 125$ kOther Cost 550 83665 0.07$ /Lb 6$ k Total Cost 1.57$ /Lb 131$ k

Profit/(Loss) Coffee 23$ k

Futures Lots Lbs RateBuy (Long) 2 75000 1.50 /Lb (113)$ kSell (Short) -2 -75000 1.30 /Lb 98$ k

Profit/(Loss) Futures (15)$ k

Combined Profit In Dollars 8.4$ In Cents/Lb 10.1 Cts/Lb

Discussion – “Market Up” Scenario

What if exporter fails to ship the coffee to the importerWhy might exporter fail to ship?

What situation does the importer face now?

How can the importer protect himself from this?

Price Fixing TechniquesPrice fixation – finalizing the price of a differential contract by applying futures

market price

“AA” (Against Actuals) Process Roaster buys futures in his own account Roaster transfers futures to importer’s account by in effect selling the futures from own

account to supplier’s Final price will be futures price transferred to importer (plus differential) AA price is supposed to be set within range of the day’s market to avoid putting a heavy

margin call on seller. It does not have to equal the price paid originally by roaster (difference = gain / loss in roasters account

Opposite process can occur with exporter…Exporter sells futures in his own account and then importer ‘buys’ them via AA to fix price

Direct Fixation Process Roaster calls importer and instructs him to the Buy the market to fix the contract price Exporter calls importer and instructs him to Sell the market to fix his contract price

Quiz: So you want to be a trader You have coffee in inventory, how do you hedge it?

Buy or Sell Futures?How would you calculate number of futures lots?

How would you know what price to sell the inventory to achieve desired profit objective?

Assume you own Colombian Coffee in the warehouse at $1.50/lb, with short hedge set at 1.25/LbAssume market is at 1.40 and you want to make a 5 Cent profitCustomer wants fixed price quote – what should you quote?Customer wants differential price quote – what should you quote?

(assume no additional costs to deliver coffee to this customer)

What action is required if:Customer accepts fixed price quoteCustomer accepts differential price quote

Trader Answers You have coffee in inventory, how do you hedge it?

Buy or Sell Futures? SELL

How to calculate number of futures lots? # Lbs to be hedged divided by 37,500 Lbs (NY ICE). For Robusta, divide by 10 Metric Tons (London)

How would you know what price to sell the inventory to achieve desired profit objective?

Assume you own Colombian Coffee in the warehouse at $1.50/lb, with short hedge set at 1.25/Lb

Assume market is at 1.40 and you want to make a 5 Cent profit

Customer wants fixed price quote – what should you quote? $1.70/Lb

Customer wants differential price quote – what should you quote? +30(assume no additional costs to deliver coffee to this customer)

What action is required if:Customer accepts fixed price quote Buy futures at 1.40

Customer accepts differential price quote None

Market Structure andHedge Rolling

Market Structure

Other than extreme market moves which can create ruinous margin calls, when it comes to futures markets, traders mostly care about the market structure, that is, the difference in value between the various futures months

In a Normal market, further-out futures months are priced higher than nearby months. This is generally a good situation for a commodity importer or trader.

In an Inverted market, the nearby months are priced higher. This is generally a dangerous situation for a commodity importer or trader.

Why?

Normal Market pays the Trader to Carry the Commodity

NY ICE Coffee Market -- Mar 22, 2010Month

Click for chart Open High Low Last Time Sett Chg

10-May 132.1 133.65 130.85 133Mar 22, 13:59

133 0.50

10-Jul 133.7 135.25 132.55 134.7Mar 22, 13:59

134.7 0.50

10-Sep 135.8 136.7 134.5 136.3Mar 22, 13:44

136.3 0.50

10-Dec 137.8 138.5 136.6 138.2Mar 22, 12:44

138.2 0.40

11-Mar 139.95 139.95 139.95 139.9Mar 22, 12:44

139.9 0.40

11-May 141.1 141.1 141.1 141.25Mar 22, 11:23

141.25 0.55

11-Jul 142 142 142 142.4Mar 22, 10:53

142.4 0.50

Session

• Trader buys 1 May future at 133 and simultaneously sells 1 July future at 134.70• In early May, he is notified by the exchange that he owns one lot of coffee for 133

• His May long futures position has been replaced by actual coffee• He is still short July at 134.70 Cts/lb

• He tries to sell the coffee to a customer for more than 134.70• If unsuccessful, he delivers the coffee to the exchange in late June for 134.70• His profit (134.70 – 133 = 1.7 Cents per Lb) compensates for the cost to hold the coffee for two months…financing, insurance, and storage charges.

Inverted Market = Trouble for TradersNY ICE Sugar # 11 Market -- Mar 22, 2010

Month

Click for chart Open High Low Last Time Sett Chg

10-May 18.7 18.85 17.59 17.84Mar 22, 13:59 17.84 -0.8

10-Jul 18.3 18.55 17.4 17.62Mar 22, 13:59 17.62 -0.69

10-Oct 17.95 18.22 17.31 17.46Mar 22, 13:59 17.46 -0.5

11-Mar 18 18.24 17.5 17.58Mar 22, 13:59 17.58 -0.41

11-May 17.4 17.6 17.05 17.14Mar 22, 13:29 17.14 -0.25

Session

• What if you tried the “carry” tactic in the Sugar Market?• What is the market telling you about the availability of sugar? If you have sugar, what should you do with it?

Using the Carry for non-Exchange Coffee Most coffee is not exchange certified, but is still hedged on the NY

ICE (Arabica) or the London (Robusta) exchangesTypical Transaction: Buy 250 69 KG bags Coffee FOB Feb Shipment for 1.50

Cost to import is 6 Cents, so total cost = 1.56Hedge by Selling 1 March at 1.30, so cost = +26

Before March “notice period,” traders “rolls” the short hedge to May• Buy 1 March at 140 and Sell 1 May at 142 (2 Cents)

Physical Market is saturated and spreads between months widen, so trader rolls hedge again all the way out to December

• Buy 1 May at 150 and sell 1 December at 159 (9 cents)

Finally, trader sells coffee for October delivery at Dec + 30Customer fixes price via AA and transfers Dec future to importers account at 142 (so final sale price is 142 + 30 = 172)Dealer’s cost to carry the coffee since it arrived in March until October was 7 cents/Lb (storage, financing, insurance)

OK Class – how much money did the importer make on this transaction?

Carry & Rollover Results – Trader’s View Cost of coffee

Coffee price FOB + 20 Cts/Lb (over March futures)

Cost to import + 6 (ocean freight etc)

Cost to carry + 7 (storage, financing, insurance)

Total Cost +33

Switch gainMarch to May + 2

May to Dec + 9

Total Switch +11

Sale +30 (over December futures)

Profit + 8 Cts/Lb (30 + 11 – 33)

Note that half of the profit came from the generous switch trades of 11 cents which exceeded the cost of carry (7 cents) by 4 cents. This is partly true because trader was able to sell coffee in October against December futures and avoided two additional months that he might have had to carry the coffee

Carry & Rollover Results – Accountant’s View

Physical SideSource Description Bags Lbs Rate $ Amt

Sales invoice Coffee Revenue 250 33069 1.72$ /Lb 57$ k

Purch inv. Coffee Cost 250 33069 1.50$ /Lb 50$ kFreight etc Import Cost 250 33069 0.06$ /Lb 2$ Storage, Fin. Carry Cost 250 33069 0.07$ /Lb 2$ k

Total Cost 1.63$ /Lb 54$ k

Profit/(Loss) Coffee 0.09$ /Lb 3$ kFutures side

Source Description Lots Lbs Rate $ AmtHedge Sell March -1 -37500 1.30 /Lb 49$ k

Buy March 1 37500 1.40 /Lb (53)$ kSell May -1 -37500 1.42 /Lb 53$ kBuy May 1 37500 1.50 /Lb (56)$ kSell Dec -1 -37500 1.59 /Lb 60$ k

Price Fix Buy Dec 1 37500 1.42 /Lb (53)$ k

Profit/(Loss) Futures (0.4)$ k

Combined Profit In Dollars 2.6$ k In Cents/Lb 7.9 Cts/Lb

First rollover

Second rollover

Appendix: Align ICE Futures Months to ContractsContract Month & Position

Futures Month Contract Month & Position

Futures Month

Jan Shipment March Jan Delivery March

Feb Shipment March Feb Delivery March

March Shipment May March Delivery March

April Shipment May April Delivery May

May Shipment July May Delivery May

June Shipment `July June Delivery July

July Shipment September July Delivery July

August Shipment September August Delivery September

September Shipment December Sept Delivery September

October Shipment December Oct Delivery December

November Shipment December Nov Delivery December

December Shipment March Dec Delivery DecemberPrice to be fixed contracts will generally be priced against the futures month per the above schedule.