Understand the interaction of Food Price Volatility. Brazils Coffee market as an example

Volatile food prices have considerable impact on food security, sparkling riots and contributing to political instability, as past shows. Research so far has shown that volatility is caused by a combination of factors like trade restrictions, financial speculations or even an expanding population, biofuel-policies and weather effects.
However, little work has been done to quantify and understand the interaction of these drivers. Furthermore, no distinction has been made between long-run pressure variables and short-run shocks. This paper provides a first quantified assessment of a comprehensive set of drivers for price formation on the global coffee market.

Example: Volatile Coffee prices

SUSFANS-researchers have taken coffee as an example, because it is one of the most traded agricultural commodities in the world, with an estimated total consumption value of some 174 billion dollars in 2012. The largest producer and exporter in 2015 was Brazil, followed by Vietnam, Colombia, Indonesia and Ethiopia.
After the global price regulation ended in 1989, the relatively high price level dropped significantly between 1990 to 1993 and 1999 to 2004. The latter sub-period (known as the coffee crisis period) was the longest period of low prices ever recorded with severe negative consequences on the economies of exporting countries.

Prices recovered strongly after 2004, reaching a 34-year high in mid-2011. However, there has subsequently been a severe deterioration in prices while costs of coffee production inputs, particularly fertilizers and labor, continued to rise. These price increases were in part driven by higher expenditures for pesticides to combat emerging large- scale diseases attacking coffee plantations and increasing fertilizer prices both squeezing the margins for labor inputs.

Looking into Brazil’s Coffee - taking future markets into account

During the regulated market period the highest volatility was recorded in years following severe climate shocks recorded in exporting countries, notably in Brazil in 1975 and 1985. During the free market high volatility was recorded in 1994 and 1997 where in 1994 a climate shock was recorded in Brazil.

Prices in the futures markets have been significantly more volatile than the yearly price indicator recorded by the International Coffee Organization. Futures prices contain additional information beyond the fundamentals of the market like production figures, trade, stocks and consumption.

The impact of those macroeconomic and financial variables is typically underestimated or entirely ignored by producers and traders, who are focusing on fundamentals, and even the academic literature on this topic seems to be void of appropriate methods and analyses.

Here, the study applies a large set of models to coffee market data including fundamental, macroeconomic, financial and climatic explanatory variables. The aim is to arrive at a better understanding of drivers’ contributions to coffee price phenomena. The researchers asses that different theoretical driving factors of coffee prices play a role as predictors of their dynamics. The study uses data from April 1990 until March 2016 for Arabica coffee. 

Outcome

The research results indicate that variables related to global macroeconomic and financial developments contain valuable information to explain the historical pattern of coffee price developments, as well as to improve out-of-sample predictions of coffee prices.

The minimal importance of our fundamental variable in terms of explaining historical variation in coffee prices shows that the percentage of price variance explained by changes in the production of Arabica coffee in Brazil does not reach more than 2.5% at any prediction horizon. A similar conclusion appliesto the group of purely financial variables, whose variation is able to explain a maximum of about 3.5% of the variance of coffee prices in the two-year ahead horizon.

Conclusions

In the free market period since the end of the global price regulation in 1989, smallholder farmers in many countries have been more exposed to fluctuations in coffee prices. This increased rural poverty as it became difficult for small producers to plan their resource allocations efficiently.

However, price trends and volatility are a major concern for all stakeholders in the world coffee market. In importing countries, price volatility makes it difficult for roasters to control processing costs. In addition, it affects profit margins along the supply chain.

As a result, risk management strategies are becoming increasingly recommended to producers in developing countries. However, the scope and applicability of these instruments can vary significantly, depending on the nature of the underlying and direct drivers of price trends and volatility.

“Improvements in market information and the application of financial risk management contributed to a decreasing role of market fundamentals driving coffee prices. Our results suggest that macro-economic and financial market variables are more important to understand and predict coffee prices. This has important implications for how individual producers, including smallholder coffee producers and producer countries, should manage the consequences of commodity price risks”, states Jesus Crespo Cuaresma, SUSFANS-Researcher from the IIASA-institute “Predictive tools appear to be key for the implementation of such risk management systems.”