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  • QA 024
    Question:
    Why do some differentials ease when futures prices rise?
    Background:
    Since coffee futures prices staged a recovery in late 2004 we are seeing lower differentials for some of the coffees we handle. Considering also that the United States Dollar has itself fallen dramatically then, in real terms, things are not that much better. Yet people speak of "an end to the coffee crisis".
    Asked by:
    Trader - Singapore
     
    Answer:

    Your question cannot be answered factually because the coffee business is in a state of constant flux. Hence what follows is simply a point of view that not everyone may agree with.

    Conventional wisdom used to be that differentials tended to widen when futures prices were low, and narrowed when futures rose.  There is however a substantial difference between the physical market for coffee and the futures markets. Futures markets essentially reflect expectations about future events while prices on the physical market tend to reflect short-term availability. 

    For the mainstream roaster the price of coffee is the landed price (basis or futures price, plus differential, plus transportation/import costs). Within that formula only the differential can be influenced, i.e. by refusing to pay the differential that is asked and switching to another, a substitute origin instead. Mainstream roasters are extremely flexible in that today's mainstream blends can be made up from very many different origin combinations. And, when prices were very low as in recent years, the abundant availability of some easily substitutable coffees was the main cause. Differentials fell across the board in tandem because the landed price reflected the short-term availability of mainstream quality in the physical market. End of conventional wisdom because the make-up of the mainstream market has changed…

    In the current situation, when supply and demand appear to be becoming more evenly balanced and futures prices have risen as a result, the roaster's landed price is going up in tandem. This in turn puts the squeeze on differentials for more easily substituted origins because "coffee is becoming expensive". In the end of course the roaster's objective is, on average, not to pay more than the competition, so as not to be out-priced at the consumer end. This then suggests that, in reality, for mainstream coffee the landed price is important only if it is out of line with that paid by the competition, or (more extreme) if it becomes so high that consumers reduce their intake.

    The preoccupation with differentials is a direct consequence of the ongoing move towards ever more standardized mainstream quality, probably entirely priced against the futures market. This is logical because to-day's mainstream quality is very close to the "basket" of qualities that the futures market represents. In this situation the differential is the only price negotiating tool… 

    Conversely when futures prices rise whilst differentials remain firm, then this could signal a market in which demand for particular coffees may be outstripping supply, putting producers (at least temporarily) in the driving seat.

    Go to 01.02.04 for more on differentials. Look at 09.01 and 09.02 for more on the role differentials play in coffee trading.

    Posted 9 June 2005

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