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Managing specialty coffee risk.

From carts on Seattle's streets to upscale gourmet outlets in suburban malls, the specialty coffee market has experienced tremendous growth in recent years. In many ways, this growth has altered the retail end of the marketing chain. While the majority of coffee still reaches consumers from supermarkets, now a good deal comes through a widespread variety of smaller entities.

The trend toward specialization raises an interesting question: how do these smaller entities address price risk? Using futures and options contracts at the Coffee, Sugar & Cocoa Exchange, Inc. (CSCE) might be a given for large multinational coffee corporations. Contract size, expertise, and other considerations might be daunting, however, for the small, specialty roaster.

To find out more about the specialty coffee business and its approach to risk management, a few specialty roasters were contacted for their thoughts.

One East Coast Specialty roaster's firm is "very conservative." All of their coffee--about 750 bags a week--is purchased on a price to be fixed basis. (see sidebar). Roasted coffee is sold on the same basis. As a result, their operation is "very tied to the market." Their risk: only the coffee on hand awaiting roasting or resale, "about a month's worth." The roaster could envision hedging if the firm had long-term, fixed sales contracts with a particular outlet. Were that the case, he would "try to lock in prices" with the futures market.

Another "fairly small" roaster in the Northwest indicated that "we don't do any hedging ourselves." Instead, they rely more on "prudent buying." Because the quantities of coffee handled are relatively small, hedging would be impractical.

In the Midwest, one specialty roaster (about 40,000 bags per month) indicated that price was not necessarily his prime concern when buying green coffee. "I book out based on a price with which I can make a profit," he said. "I am not too concerned with small fluctuations in the market. We look for quality green coffee first, price second."

In short, his customers are most concerned with taste. While larger roasters might compete on a price basis, he is competing on a quality basis. He says that as long as specialty coffee drinkers like the taste, it doesn't matter if they are paying six cents per cup or 10 cents per cup. "We are talking about a more educated palate," he said.

His customer base and relatively small operation do not require him to "react every time the market sneezes." When coffee went down below sixty cents in 1992, he didn't immediately cut all his prices, he said. "I sat for a month and evaluated the situation, then I selectively cut prices and offered my customers different opportunities." He added, however, that being small and having good customer relationships give him an advantage in those situations.

Small Means Flexible

Because they compete on quality, not price, the specialty coffee roaster has more flexibility than a larger roaster. In other words, they are better able to absorb slight raw material price increases while waiting for market conditions to change, or pass increased costs onto their customers.

"The smaller roasters can better absorb price increases," said a larger roaster in the South. "They are not dealing on a level where a few cents per pound changes can be disastrous."

Moreover, the specialty coffee business is still relatively small. Specialty roasters in most regions are not facing the kind of market saturation that would force more price-based competition.

No Economies of Scale

No need to read between the lines here. Clearly, the specialty roasters we spoke with feel that they are too small to use the CSCE futures and options markets. Small roasters generally believe that the costs of using CSCE markets--in margin deposits and time--outweigh the potential benefits hedging. In short, the economies of scale that large, multinationals enjoy are absent.

Being small, however, doesn't mitigate price risk. Unfavorable price movements do not discriminate. A 10 cents/pound loss is a 10 cents/pound loss, be it for a small retail operation or a huge roaster.

How is that risk addressed? Some specialty roasters cite residual benefits realized when doing business with cash market operators who hedge. Beyond that, most seek to shop carefully when purchasing green coffee--buy and sell on a fixed-price basis, don't carry too much inventory. It's not that they do not care about futures-oriented risk management, they just don't think it is possible.

Certainly, these specialty coffee roasters are doing something right, as business continues to boom. James Bowe, CSCE senior vice president for market development and planning, thinks that hedging with options could make things even better.

"From the small roaster's point of view, it is easy to see why they are not using our markets," he said. "There are a lot of considerations. Using CSCE options, however, a small roaster can circumvent many of those considerations. And, potentially do an even better job of protecting the bottom line."

The most attractive feature of buying options? Because an option holder is under no obligation to enter the futures market, losses are strictly limited to the purchases value plus whatever commissions are incurred. There are no margin calls. No danger of unwanted delivery.

If the option never becomes valuable, the holder can simply let it expire worthless. Potential gains-- gains that can spell protection against unfavorable cash market price movements--can be unlimited, net of the options' cost in premium and commissions.

A small roaster can purchase call options to guard against cash market losses that might result from rising markets. Conversely, he can buy put options to guard against losses precipitated by falling markets. If the cash markets never move unfavorably, the roaster will lose nothing more than the premium paid and commissions. And, will enjoy the resulting benefits from higher or lower than expected prices.

"In other words," Bowe said. "Buying options can be like buying insurance. If there is catastrophe, the policy is there. If there are no problems, the only thing lost is the premium paid."

Enhancing the Bottom Line

While the small roaster can shop intelligently to get a good price for his coffee, the roaster who locks in a price with options can gain a significant competitive edge.

Bowe concedes that hedging with options might not be for everyone, either. But, he is quick to point out that the Exchange is able and willing to help any specialty roaster who wants to learn more.

"We have computer software, brochures and people to talk to," Bowe concluded. "I encourage anyone with an interest to give us a call."

The Exchange can be reached toll free at 1-800-HEDGE IT or (212)9382966, Fax: (212)524-9863.
COPYRIGHT 1993 Lockwood Trade Journal Co., Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:includes related article on "Price-to-be Fixed Transactions"
Author:Plourd, Philip G.
Publication:Tea & Coffee Trade Journal
Date:Jan 1, 1993
Previous Article:Roasters talk about the coffee business: 1993 and beyond.
Next Article:American altruism in action.

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